Financial ratio analysis

04/11/23 1

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

04/11/23 2

Financial Ratio Analysis

04/11/23 3

SIGNIFICANCE OF RATIO ANALYSIS

CSD ‘A’ earns Rs 50,000 CSD ‘B’ earns Rs 40,000

Which is more efficient? A or B

CSD ‘A’ has emp Rs 4,00,000CSD ‘B’ has emp Rs 3,00,000

Profit as a % of Capital emp ‘A’ = (50,000/ 4,00,000) * 100 =12.50% ‘B’ = (40,000/ 3,00,000) * 100 =13.33%

04/11/23 4

RATIO

A ratio is a statistical yardstick that

provides a measure of the relationship

between two variables or figures.

LIABILITIES 31MAR07

31MAR08

ASSETS31MAR07

31MAR08

170 SHARE CAPITALEQUITYPREFERENCE

12050

170 213 FIXED ASSETS NETGROSS STOCKLESS DEPRECIATION

594365

229

180 RESERVES AND SURPLUSES

215 11 INTANGIBLE ASSETS

15

150 SECURED LOANSDEBENTURESLOANS /ADVANCES

50101

151 5 INVESTMENTS 5

20 UNSECURED LOANS

30 670 CURRENT ASSETS

CASH IN BANKRECEIVABLESINVENTORIESPRE-PAID EXPENSES

73189355

64

681

409 CURRENT LIABILITIESSUNDRY CREDITORSPROVISIONS

33069

399

30 MISC EXPDR/LOSSES 35

929 TOTAL (Rs Lacs) 965 929 TOTAL (Rs Lacs) 965

BALANCE SHEET ABC COMPANY AS AT 31 MAR2008

INCOME STATEMENT OF ABC COMPANY FOR YEAR ENDED 31 MAR 08

FIGS 2007 FIGS 2008

847 NET SALES 904

657 COST OF GOODS SOLD STOCKSWAGES AND SALARIESOTHER MANUFACTURING EXPENSES

366188160

714

190 GROSS PROFIT 190

103 OPERATING EXPENSES: SELLING/ADMDEPRECIATION

7125

96

87 OPERATING PROFIT 94

11 NON-OPERATING PROFIT/DEFICIT 49

98 PROFIT BEFORE INTEREST&TAX (EBIT)

143

26 INTEREST(ON BANK BORROWINGS/LOANS)DEBENTURES

294

33

72 PROFIT BEFORE TAX 110

36 TAX 58

36 PROFIT AFTER TAX 52

12 DIVIDENDS:EQUITY/ PREFERENCE 14 / 3 17

24 RETAINED EARNINGS(RESERVE & SURPLUS)

35

04/11/23 7

A comparison is more useful than mere Nos Analysis of financial ratios involves two types

of comparisons: Present ratio with the past ratios & expected future

ratios Ratios of one firm with those of similar firms or with

industry averages at same point of time

Essential to consider nature of business

(apples cannot be compared with oranges)

WHY BOTHER WITH RATIOS?

04/11/23 8

CLASSIFICATION OF RATIOS

Liquidity ratios

Leverage / Solvency ratios

Turnover / Activity ratios

Profitability ratios

Valuation ratios

04/11/23 9

LIQUIDITY RATIOS

Current ratio

Quick / Acid test ratio

Shows ability of company to pay its current financial

obligations

Company should not be selling its assets at a loss to

meet its financial obligations; worst scenario be forced

into liquidation

04/11/23 12

CURRENT RATIO (CR)

Measure of company’s ability to meet short term

requirements

Indicates whether current liabilities are adequately

covered by current assets

Measures safety margin available for short term creditors

CR = Current assets/Current liabilities

If Net Working Capital is to be positive, CR >1

Indian avg for non banking industries is 2

Current assets = 681

Current liabilities = 399

CR = 681/399 = 1.71

04/11/23 13

CURRENT RATIO (CR) - IMPORTANCE

Higher ratio ensures firm does not face problems

in meeting increased working capital requirements

Low ratio implies repeated withdrawls from bank

to meet liquidity requirements

High CR as compared to other firms implies

advantage of lower int rates from banks

04/11/23 14

ACID TEST RATIO/QUICK RATIO(QR)

Used to examine whether firm has adequate cash or cash

equivalents to meet current obligations without resorting

to liquidating non cash assets such as inventories

Measures position of liquidity at a point of time

QR = Quick Assets / Current Liabilities

Quick assets = Current assets – (inventories + prepaid

expenses)

= 681–(355+64) = 262

Current liabilities = 399

QR = 262/399 = 0.66

As a thumb rule ideal QR = 1; should not be less than 1

04/11/23 15


Liquidity ratios




Valuation ratios

04/11/23 16

LEVERAGE RATIOS

Shows dependence of firm on outside long term

finance

Shows long term financial solvency & measures firm’s

ability to pay interest & principle regularly when due

To assess extent to which the firm borrowed money vis-

à-vis funds supplied by owners; Use of debt finance

Companies whose EBIT <= Interest payments are risky

Debt - Equity ratio

Debt - Total fund ratio

Debt - Assets ratio

Interest coverage ratio

Liability coverage ratio

04/11/23 17

Measures relative proportion of debt & equity in financing

assets of a firm

Company can have good current ratio and liquidity

position, however liquidity may have come from long term

borrowed funds, the repayment of which along with

interest will put liquidity under pressure

DER = Long term debt / Share holders funds

Creditors would like this to be low; Lower ratio implies

larger credit cushion (margin of protection to creditors)

IDB expects DER of 2:1 in respect of SMEs

DEBT EQUITY RATIO

04/11/23 18

Debt (loans) = Secure loans + Unsecure loans

= 151+30=181

Share holders funds = (equity+ preference capital +

res & surplus – fictitious assets &

accumulated losses not

written off )

= 120+50+215 = 385

DER = 181/385 = 0.47 = (0.47:1)

Creditors are providing Rs 0.47 financing for each

rupee provided by shareholders

DEBT EQUITY RATIO

04/11/23 19

DEBT – TOTAL FUND RATIO

DTF ratio= Long term debt / Total fund

Debt (long term) = 181

Total funds (debt + sh holders’ funds) =

181+(170+215-35) = 531

DTF ratio = 181/531 = 0.34

34% of the firms funds are debt (of various types)

remaining 66% is financed by owners/ share holders

Higher the debt - total funds ratio, greater the

financial risk

04/11/23 20

DEBT – ASSETS RATIO

Debt - Assets ratio = Debt / Net assets

Debt = 181

Net assets (less fictitious assets & losses) =

930

Ratio = 181/930 = 0.19

19% of the firms assets are financed with debt (of

various types).

Shows coverage provided by the assets to total

debt

04/11/23 21

INTEREST COVERAGE RATIO

Gives ability of company to pay back long term

loans along with interest or other charges from

generation of profit from its operations

Interest coverage ratio = EBIT / Debt interest

EBIT = 143

Interest = 29+4 = 33

Ratio = 143/33=4.33

EBIT should be 6 – 7 times of debt interest

Shows margin of cover to lenders; of prime imp

04/11/23 22

LIABILITY COVERAGE RATIO

Calculated to determine time a company would take to

pay off all its liabilities from internally generated funds

Assumes that liabilities will not be liquidated from

additional borrowings or from sale of assets

LCR = Internally generated funds / Total liabilities

Internally gen funds = Equity + Pref + R&S = 385

Total liabilities = 965

LCR = 385/965 = 0.399

Firm will take 2.5 yrs (1/.399) to repay all its liabilities

04/11/23 23


Liquidity ratios




Valuation ratios

04/11/23 24

ACTIVITY / TURN OVER RATIOS

Allows to examine whether total amount of each type

of asset a company owns is reasonable, too high or too

low in light of current and forecast operating needs

In order to purchase / acquire assets, companies need

to borrow or obtain Capital from elsewhere :- More assets acquired implies high int and low

profits Lesser assets implies operations not as efficient as

possible

Activity turn over ratios used to assess efficiency with

which company utilizing its assets

Relates to level of activity represented by sales or cost

of goods sold

• Inventory turnover ratio

• Average collection period

• Fixed assets turn over ratio

04/11/23 25

Measures No of times inventory turned over in a yearOR

No of days of inventory held by company to sp sales Times Inventory turned over =

Net sales OR COGS

Avg inventory Avg stocks Inventory measured in days of sale =

365 x Avg inventory

Net Sales

INVENTORY TURN OVER RATIO

04/11/23 26

A ratio of 6 times indicates inventory turned over six times in a year

OR Ratio of 60 days indicates enough inventory to support sales for 60 days held by company

Excessive inventories unproductive; represent investment with zero rate of return

Conversely less inventory results in loss of customers

ABC’s ratio = 904/355 = 2.54 ABC’s Days of Inv = (355 x 365)/904 = 143.33 days

INVENTORY TURN OVER RATIO

04/11/23 27

AVERAGE COLLECTION PERIOD Represents duration a company must wait after making

sales, before it actually receives cash from its

customers ACP = Avg receivables OR

Average sales per day = Avg receivables x 365

Sales

Imp For assessing effectiveness of credit policy of firm Enables mgmt to take timely measures to effectively

manage credit Too high value - firm facing difficulties in collecting debts Too low value - restrictive credit policy

Receivables = 189

Sales = 904

ACP = (189 x 365)/ 904 = 76.2 days

say 76

days

04/11/23 28

FIXED ASSETS TURNOVER RATIO

Measures effectiveness of utilization of fixed assets by

company

Used to compare fixed assets utilization of two firms

Not truly reflective of performance / efficiency

High ratio (depreciation) if old assets

Low ratio if capital assets procured recently

FATR = Net sales (or COGS)/ Fixed assets

Higher ratio indicates better utilisation of assets (with

a caution on age of assets)

Fixed Assets = 229

Net Sales = 904

FATR = 904 / 229 = 3.95

04/11/23 29


Liquidity ratios




Valuation ratios

04/11/23 30

PROFITABILITY RATIOS

Gross profit margin ratio (GPMR) Net profit margin ratio (NPMR) Return on investment

• Profitability ratios indicate

• Company's profitability in relation to other

companies

• Internal comparison with last yrs profits

•Managements effectiveness as shown by

returns generated on sales and investments

04/11/23 31

GROSS PROFIT MARGIN RATIO(GPMR)

Represents cost of production

Helps in understanding proportion of raw materials

used and direct expenses incurred in overall

production process

Reflects income being generated which can be

apportioned by promoters

Reflects efficiency of firm’s operations as well as how

products are priced

GPMR = Gross profit/ Net sales

Net Sales = 904

Gross Profit = Net sales - COGS = 904 - 714 = 190

GPMR = Gross Profit / Net sales

= 190 / 904 = 0.21 = 21%

Implies 79% (100-21%) of sales contribute towards

direct expenses and raw mtrl

04/11/23 32

NET PROFIT MARGIN RATIO(NPMR)

Takes into account not only cost of production but

also administrative expenses like staff salary, selling

& distribution overheads

Represents surplus of gross profit after meeting

expenses

Net profit appropriated to meet tax liability, dividend

payments and to retain part in business

NPMR = Net profit (Profit after tax)/ Net sales

Net Sales = 904

Net Profit after taxes = 52

NPMR = Net Profit / Net sales

= 52 / 904 = 0.057 = 5.7%

Implies for every Rs 100/- of sales, Rs 5.7/- earned

as profit which can be used for dividend distr and

apportioned to res & surplus• Company B has outperformed Company A in total sales

• However A has utilized its resources more efficiently

COMPANY A COMPANY B

SALES 2,00,000 2,50,000

GROSS PROFIT 40,000 40,000

NET PROFIT 20,000 22,000

GROSS PROFIT MARGIN

20% 16%

NET PROFIT MARGIN 10% 8.8%

04/11/23 33

PROFITABILITY IN RELATION TO INVESTMENT- RETURN ON INVESTMENT (ROI)

Indicates efficiency with which company used its

Capital (Equity as well as debt)

Takes into account overall returns of the company

assuming company has not taken any debt

Gives overall returns including adjustments of

earnings for fin leveraging

Enables one to check whether return made on

investment is better than other alternatives available

Suited for inter-firm comparisons

ROI = EBIT x100 / Capital employed

• EBIT = 143

• Capital employed = 566 ( (120+50+215+181)-

(0+0) )

(Eq +Pref sh +Res & surp+Debt)-(Fictitious assets

+ Non operating investments)

• ROI = 143/566 x 100 = 25.26 %.

• The company has earned a profit of 25.26 paise on

every 100 Re invested

04/11/23 34


Liquidity ratios




Valuation ratios

04/11/23 35

VALUATION RATIOS

Earning per share (EPS)

Price Earnings (PE) Multiple

Price Earnings Growth (PEG) Multiple

Dividend Payout Ratio

Dividend Yield

Beta of Stock

04/11/23 36

EARNINGS PER SHARE(EPS)

Represents total earnings of a company available for

distribution among equity shareholders

Evaluates performance of company shares over a

period of time

EPS = Net profit available for equity shareholders / No

of Equity shares

EPS alone should not be basis of decision making with

respect to purchase of any company share

Faulty reasons of High EPS Less No of Equity shares Investment in risky ventures

04/11/23 37

PRICE EARNING (PE) MULTIPLE

Simplest method of comparing different stocks at a

point of time to make investment decisions

As a layman, this is the price being paid for buying

one rupee of earning of a company eg If PE of Infosys

share is Rs 9/- it means we are paying to the market a

price of 9 for every Rs 1/- earning of the company

PE Ratio = Market Price per share/ EPS

04/11/23 38

PRICE EARNING GROWTH (PEG) MULTIPLE

An extension of PE which also takes into account

growth rate of the company

PEG Multiple = PE / Growth

COMPANY A

COMPANY B

Analysis

Market Price 200 200

EPS 10 20

Growth rate 5% 2%

PE Multiple 20 (200/10) 10 (100/20) A overvalued

PEG Multiple 4 (20/5) 5 (10/2) B overpriced wrt growth potentialWhich company stocks to be purchased ?

04/11/23 39

DIVIDEND PAYOUT RATIO Shows amount of dividend paid out of earnings

An indication of amount of profits put back into company

Imp ratio to assess long term prospects of company

Dividend Payout Ratio = Dividend / Net Income

04/11/23 40

DIVIDEND YIELD

Shows relationship between Dividend per share and market price

An imp ratio to compare two companies

Dividend Yield (%) = Dividend amount per share *100

Market price of share

04/11/23 41

BETA OF SECURITY

Refers to overall market risk which a security is carrying

and which cannot be diversified

Responsiveness of share price of a company with respect

to overall market movement

If over a period of time, market has given a return of

20%; individual share of company ‘A’ has given return of

10%;

Beta of A = 10 / 20 = 0.5

If investor is risk averse, should invest in stocks with low

Beta; Even if market falls by drastic amount his

investment will not take that much hit

04/11/23 4204/11/23 42

FINANCIAL RATIOS

.

LIQUIDITYNWC = CA - CLCR = CA/CL

ATR = (CA –INVENTORY)/CL

LEVERAGEDebt-Equity Ratio = Debt/Net WorthLiab Coverage Ratio = Int gen funds / Total Liab Debt to Assets Ratio = Debt/Total Assets Interest Coverage Ratio = EBIT/Debt InterestACTIVITY/TURNOVER Inventory Turn Over Ratio = Net Sales/Inventory

FATR = Net Sales/Total Assets Avg Collection Period = 365/ RTOR

PROFITABILITYGPMR = Gross Profit/Net Sales

NPMR = Net Profit/Net Sales ROI = EBIT x 100/ Capital ROE = Equity earnings/ NW

Solvency , Safety Margins, Idle Resources , Risk

Long term solvencyRisk due to debtOwners StakeCoverage provided by assetsInterest burden

UtilisationCredit mgtRestrictionsEfficency

EfficencyAcceptabilityOverall performanceMargin of SafetyAbility for PAT

Economy & Finance

Financial ratio analysis